Lebanon should, however, weather the short-term financial and political pressures resulting from the assassination of its former Prime Minister. A favorable economic conjunction, underpinned by replenished reserves, prospects for higher economic growth, robust financial sector liquidity, and active debt management, mitigates the risk of an immediate financial crisis. Medium-term prospects continue to hinge on maintaining political stability and reinvigorating Lebanon's burgeoning structural reform agenda.

After Syria's direct military and political roles in Lebanon apparently came to an end following internal and international pressure, indicators that potential economic activity can resume exist. Real economic growth was strong before the crisis, averaging 5% in 2004, for example. Capital flows from the Gulf have favored Lebanon, averaging almost 11% of GDP annually in 2001-2004. Moreover, rapid improvements in external liquidity since the crisis' peak in April 2005 have provided the BDL with flexibility to weather potential pressure on the Lebanese pound. Gross foreign-exchange reserves, excluding commercial banks' reserves and gold, amounted to $14.9 billion at Aug. 31, 2005, above their amount at the end of 2004.

Caught in a power struggle with his long-time rival, President Emile Lahoud, Rafik Hariri was largely unable to push ahead with fiscal and structural reforms. Mr. Hariri did manage to develop a reform agenda, however. A failure by his successors to step up the implementation of long-awaited reforms after the parliamentary elections in May 2005 that gave them a clear majority would undermine growth and investment inflows, eroding confidence and heightening the risk of further financial turbulence. Conversely, a prolonged period of fiscal consolidation would strengthen debt sustainability, underpin confidence, promote Lebanon's economic renaissance, and strengthen its credit standing, as well as that of its financial sector.

Standard & Poor's believes that the Lebanese banking system would be negatively affected if there were a sharp devaluation. The major risk is not exchange, however, because banks are forbidden to have an open foreign currency position of more than 5% of their shareholders' equity, but are permitted by the central bank to hedge a maximum of 60% of their equity (they are allowed to hold their capital in U.S. dollars, for example). Standard & Poor's would, however, expect some deterioration in loan quality in the case of a severe devaluation, and consequent higher provisioning requirements, depending on the devaluation's intensity and suddenness. Economic conditions are also likely to prove very sluggish after a devaluation because business confidence would collapse and the diaspora would be likely to slow transfers. This would have an impact on asset quality, especially because there would be a lag before the greater competitiveness of Lebanese exports was felt.

For Lebanon, the GPA ratio is 25%-40%. This reflects:

The 10 largest banks accounted for about 75% of the sector at Dec. 31, 2004, with a fair degree of concentration. Appendix 2 below provides selected financial data and ratios for the 10 largest Lebanese banks for 2003 and 2004. Banks rated by Standard & Poor's--namely Blom Bank sal (B-/Stable/--), Bank Audi SAL - Audi Saradar Group (B-/Stable/C), and Banque de la Méditerranée sal (B-/Stable/C)--are among the five largest in the country. Despite concentration, no single bank overwhelmingly dominates the market. None has market shares in loans or deposits exceeding 16%.

Financial services in Lebanon, with the exception of insurance, are intermediated almost wholly by the banks because there are very few nonbank financial services providers. This is a positive factor supporting the ratings on Lebanese banks, and no threat to this key franchise is imminent. The domestic capital markets (particularly stock markets) remain in their infancy. Very few companies are listed on the Beirut stock exchange, and the market will remain narrow until there is further privatization. On the debt side, there is virtually no domestic bond market apart from government paper. Some of the largest banks have increased issuance of dollar certificates of deposit (CDs) in the past three years, prompted by the drop in interest rates. Preferred shares seem to be the most attractive means for large Lebanese banks to raise capital and fund growth without jeopardizing the position of their historical shareholders.

Regional expansion is another area where Lebanese banks are allocating significant time and resources. Now that Lebanese banks have been allowed to invest up to 25% of their equity base in overseas operations, leading players are eyeing neighboring markets where adding value is possible. Egypt, Jordan, and Syria are Lebanese banks' most natural targets, although Iraq, North Africa, and Gulf countries are also attracting much attention. Table 2 provides a snapshot of the most significant regional moves involving major Lebanese banks in over the past two years. This expansion strategy is mainly funded through share issues (Byblos Bank sal doubled its share capital in 2005) or preferred shares (an option chosen by both Blom Bank and Bank Audi Saradar).

Under Standard & Poor's criteria, a persistently high level of dollarization reduces the incentives that a sovereign government may have to interfere in the foreign exchange activities of corporations, even in the face of a sovereign default. The exceptionally high level of commercial banks' exposure to the public sector (24% of the asset base, and 53% when deposits with the central banks are included), means that the Lebanese banks are too tied to the fortunes of the Lebanese state for there to be realistic delineation between them and the sovereign. This is especially the case because the banks have increasingly been the major investors in the U.S. dollar-denominated instruments the government has been issuing to reduce its cost of funding, in addition to Lebanese pound-denominated treasuries. Lebanese banks would, therefore, be very exposed to any sovereign default. This means that the ratings on Lebanese banks will continue to be at or below the sovereign ratings for the foreseeable future.

The level of NPLs tends to be inversely proportional to the size of the banks, underlining the need for the smallest ones to be consolidated into stronger institutions where the risk can be more effectively managed and absorbed. Standard & Poor's expects the cost of lending risk to continue to be high in the medium term, despite the increasing proportion of retail lending in credit portfolios. The still fairly high NPLs, at 11.0% of loans at the end of 2004, excluding IIS, reflect the relatively risky nature of the lending business in Lebanon, despite the conservative approach of most top-tier banks in the country. Excluding both IIS and specific provisions, the NPL ratio was 7.95% at Sept. 30, 2005. Given the low loan leverage of 22% in 2004, however, NPLs net of provisions represent less than 10% of Lebanese banks' equity base. The recent crisis did not trigger any significant deterioration of NPL ratios because it was short and mostly affected banks' dollar liquidity.

The regulator is very closely involved in the classification of the banks' loan portfolios, and considers current provisioning adequate. Up to 2002, when coverage of NPLs by loan-loss reserves had been constantly declining, Standard & Poor's considered the provisioning trend to be an additional cause for concern, at a time when the economy was still struggling to recover. Banks were expected to be increasing their level of protection in this context, but profitability was not sufficient to allow for conservative enough provisioning. Since 2002, however, NPL ratios have been trending down and provision coverage has been more satisfactory, above 70%.

The construction sector accounts for almost 20% of outstanding loans, showing how exposed the banking system is to potential problems in the real estate market. Banks are further exposed by their fondness for taking real estate as collateral. Lending risk is heightened due to concentrations on single obligors or groups, itself a reflection of the limited number of good-quality lending opportunities in the country at present, although such concentration levels are not outrageous.

The banks' high surplus liquidity is channeled into government paper, deposits at the BDL, and cash placements with international banks (together accounting for as much as two-thirds of their balance sheets). Lebanese banks' direct exposure to the sovereign, including deposits at the central bank, were L£54.9 trillion at Sept. 30, 2005, or about 7x their equity base. Investments in Lebanese T-bills generally account for almost all their Lebanese pound liquidity. Standard & Poor's rates the local currency obligations of the Republic of Lebanon 'B-'. A local currency default would sound the death knell for much of the banking system because the banks would have no liquidity to supply the inevitable run on their Lebanese pound deposits, thereby simultaneously killing confidence in both the central government and the banking system. Another concern about the high level of assets allocated to government debt is that it does not build franchise value in the banks. It also tends to crowd out lending to the private sector, which, owing to the wide differential in yields between government papers and corporate loans, is must resort to self-financing.

Profitability. Lebanese banks' profitability has deteriorated during the past five years. The whole Lebanese banking sector suffered from the difficult economic environment, and the declining yield on government debt. Net interest income remains the driver of Lebanese banks' profitability, and so the net interest margin largely shapes financial results. In 2002-2004, banks collectively agreed to subscribe to about $4 billion in zero interest-rate T-bills as a form of contribution to fiscal adjustment efforts. Such a decision, coupled with the relatively high amount of fixed assets on banks' balance sheets, increased the proportion of nonyielding assets, limiting the system's ROA to a low 0.5%-0.8% over the past five years. In 2005, zero interest-rate T-bills matured, but the political crisis delayed their replacement by higher-yielding assets in the form of domestic and international new credit production. In addition, during the 2005 crisis, the banking sector suffered a shock on Lebanese pound interbank rates (and to a lower extent on dollar rates), the cost of which was partially compensated by the central bank's issuance of $2 billion of new 10-year dollar CDs (callable after seven years), and new longer-maturity Lebanese pound instruments swapped against existing T-bills, at above-market average rates (see "Crisis Management" below).

The central bank and the BCC carefully coordinate their activities. It is not unknown for the BCC to initiate changes in the regulatory environment, perhaps by writing to the Governor of the BDL on a specific issue. The BDL has a duty to consult the BCC on issues such as banking licenses and requests to open new branches. The BCC has access to all information available to the BDL regarding the financial structure and administrative status of all institutions of the banking sector. The BCC has a separate budget, which has to be ratified by the Higher Banking Council. It has full autonomy to manage internal administrative matters, of which the most important is the overseeing of staff and professional examiners. This includes issues of hiring and firing, salary management, promotions, retirement, and staff training.

The key to understanding Lebanon's previous role in Middle East banking is the Republic's 1956 Banking Secrecy Law. This remains one of the key distinguishing features of Lebanese banking. All banks established in Lebanon and all branches of foreign banks are subject to this law. It is an offence for any bank employee, including top management, to reveal their knowledge of clients' names, assets, or holdings to any individual, even those in authority, without the written authorization of the client. Banking secrecy does not apply, however, in cases of bankruptcy or litigation between bank and client. Moreover, banks are permitted to communicate problem names among themselves to ensure the solidity of the banking system.

In July 2002, The Financial Action Task Force (FATF) in charge of countering money laundering decided that Lebanon had made significant progress toward the full implementation of the law on money laundering, justifying its removal from the GAFI list of noncooperative countries and territories. Law number 318 addressed the FATF's major concerns with regard to bank secrecy, by creating Special Investigation Commission (SIC) to receive and review suspicious transactions. The SIC is empowered to lift bank secrecy, investigate suspicious transactions, and ensure compliance with law number 318.

Table 5 summarizes the main regulatory requirements Lebanese banks must meet.

Banks submit regular reports to the BDL that must include monthly statements of their daily foreign-exchange positions, weekly reports on their Lebanese T-bill portfolios, monthly information on customers and interbank deposits, and audited financial statements. Banks also submit monthly reports to the BCC, which must include monthly financial statements and information about their loan portfolios (exposure to related parties and large exposures). The BCC generates reports from bank returns, which may alert the off-site examiner to a particular issue or problem and trigger an immediate audit. The BCC acknowledges the need for regular on-site inspections, but also considers the returns to be important tools if used properly.

Although there is no hard and fast definition of bad loans in Lebanon, the BCC has to approve any provisions that banks propose (in order that they can be tax deductible). The BCC is therefore deeply involved in the classification of problem credits. The on-site examination of banks' loan portfolios, for example, is very detailed, usually covering 90% of loans. The BCC can insist on provisions being made for loans or on the accrual of interest on a certain position.

In the future, a privately held bank may be persuaded to take over a troubled institution in similar circumstances. The BDL can provide liquidity support to banks through the following means: